Does Hasbro Have Iron Man's Head in the Sand?

Nothing will stop five-year-old boys falling in love with characters from the Avengers or Spider-Man. But five-year-olds don’t control the family budget, so the odds that superhero mania will translate into superlative earnings for Hasbro Inc. (HAS) any time soon appear slim.

That’s grim news for the company, which Standard & Poor’s Ratings Services has just put on credit watch for a possible downgrade, based in part on the probability that earnings won’t live up to expectations for the fourth quarter of 2012 and for the year as a whole. Late last week, Hasbro announced that it expects to report earnings of $2.73 to $2.75 (excluding restructuring charges but including a hit on foreign exchange, while analysts had been anticipating a figure closer to $2.85 a share.)

The revenue picture is even more depressing. The company now expects to see revenues slide 3.8%, while analysts had been predicting a reasonably healthy 6% advance.

Aware that remorseful confessions wouldn’t pass muster with investors unless accompanied by action, Hasbro plans to cut 10% of its workforce, as part of a cost reduction program that will deliver its full benefit – cutting $100 million from the expenses line in the budget -- by 2015. That may help cut costs and increase the firm’s financial flexibility, but a more critical question is whether Hasbro has a plan in mind to address the fact that these days, kids are even happier to play the latest games online than to take their G.I. Joe and superhero “action figures” outdoors and invent elaborate scenarios of their own.

The nature of the financial problem Hasbro faces can be seen clearly in the chart above: its free cash flow has declined in the last five years, and debt levels and interest expense roughly doubled in the same time frame.

The second part of the equation is more problematic. Children, as Hasbro has said, are turning to electronic toys at an ever-younger age, and if the company can’t find a way to adapt to that trend, it is hard to imagine the company staging a decisive rebound any time soon. For now, Hasbro hasn’t committed to jumping onto the tablet gaming bandwagon. Instead, it is dipping a toe into the water, forging an agreement with PopCap Games, a division of Electronic Arts Inc. (EA). PopCap has ushered a number of top-tier virtual games to stardom, including Bejeweled; Hasbro now will be taking those game concepts and turning them into 20th-century style physical games. Purchasers of Hasbro’s version of Bejeweled will be able to download a new virtual game, Bejeweled 3, for free.

This might work, but it’s hardly likely to rattle the confidence of the folks over at LeapFrog Enterprises (LF), whose LeapPad2 tablets were big sellers over the holiday season. That product is squarely on target, offering parents a device that they can feel comfortable putting in the hands of their children (in contrast to the adult-oriented iPads or Kindle Fire devices) and that offers educational content, even as it satisfies the yearning of the kids in question to have their very own tablets. It doesn’t help the outlook for Hasbro that LeapFrog’s PE ratio makes its valuation look more attractive than that of the older toy maker. Let your kid convince you to buy an Iron Man toy, but don’t take the next logical step and snap up Hasbro shares until there is convincing evidence not only that cost cutting is working but that the company has developed a compelling strategy for the digital age.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.